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January 18, 2011

Larry McMillan's 2010 Market Review & 2011 Forecast

For the past 20 years, Larry McMillan of McMillan Analysis has published The Option Strategist newsletter, including his annual market review and forecast with his expert assessment and predictions. Here, Larry has generously agreed to share an excerpt from this year's review and forecast focused on market volatility. To read more from the 2011 Market Forecast, click here.

Let us look at another representation of volatility. This is some new research that we have done recently. First, let’s review the concept of seasonal volatility. We usually present that in an annual view, as in Figure 7—which is the seasonal computed including this past year’s numbers (we use $VXO because it has a longer data history than the “new” $VIX). Since we had high volatility in May through July and low volatility in October, point C is higher than it used to be, and point F is lower. But the general concept is still the same: volatility is modest in the beginning of the year, then falls to the year’s lows about July 1st, then explodes into October, and then—often to the surprise of many, even though it happens frequently—volatility falls precipitously during the fall of the year, so that by Christmas, it’s almost back at the year’s lows. That is the case again this year.

Figure 7

The new research involves taking this same concept and applying it to the 4-year Presidential cycle. Obviously we don’t have as many data points if we are taking 4-year “blocks” of data, but Figure 8 shows what this looks like. The numbers on the X axis represent the number of days into the approximately 1000-day cycle the data point lies. The red lines on the X-axis roughly divide the four years. We have just completed the far right-hand year (one which typically has a big rise in volatility but then it tails off dramatically at the end—which is exactly what has happened this year).

The election year is the most volatile. Since we only have five data points, this is heavily influenced by the market declines in 2000 and 2008.

Figure 8

Theoretically, the low point of the 4-year cycle is in the mid-term year between Presidential elections (the far right-hand year on Figure 3). That should theoretically be the peak in volatility. While there is a peak in that year, it has been superceded in recent years by the election year itself.

The “template” for 2011 is the far left-hand year on the chart. It is the least volatile, with volatility remaining in a relatively narrow range over the course of the year. It is interesting to note this pattern, because 2007 is included there – a year in which volatility started very low and exploded by year-end. However, the other years totally dominated that action to present the result shown on the chart. So, by thisaccount, we can’t really expect a volatile year in 2011.